Evaluation and Control Chapter 11

Copyright © 2015 Pearson Education, Inc. Learning Objectives Understand the basic control process Choose among traditional measures, such as ROI, and shareholder value measures, such as economic value added, to properly assess performance Use the balanced scorecard approach to develop key performance measures Apply the benchmarking process to a function or an activity Develop appropriate control systems to support specific strategies including performance measurement After reading this chapter, you should be able to: Understand the basic control process Choose among traditional measures, such as ROI, and shareholder value measures, such as economic value added, to properly assess performance Use the balanced scorecard approach to develop key performance measures Apply the benchmarking process to a function or an activity Develop appropriate control systems to support specific strategies including performance measurement Copyright © 2015 Pearson Education, Inc.

Evaluation and Control Process Figure 11-1 Evaluation and control information consists of performance data and activity reports (gathered in Step 3 in Figure 11–1). Copyright © 2015 Pearson Education, Inc.

Measuring Performance end result of activity Steering controls measure variables that influence future profitability Cost per available seat mile (airlines) Inventory turnover ratio (retail) Customer satisfaction Performance is the end result of activity. A firm, therefore, needs to develop measures that predict likely profitability. These are referred to as steering controls because they measure variables that influence future profitability. Every industry has its own set of key metrics that tend to predict profits. Airlines, for example, closely monitor cost per available seat mile (ASM). An example of a steering control used by retail stores is the inventory turnover ratio, in which a retailer’s cost of goods sold is divided by the average value of its inventories. Another steering control is customer satisfaction. Copyright © 2015 Pearson Education, Inc.

Copyright © 2015 Pearson Education, Inc. Types of Controls Output controls specify what is to be accomplished by focusing on the end result through the use of objectives Behavior controls specify how something is done through policies, rules, standard operating procedures and orders from supervisors Input controls emphasize resources Output controls specify what is to be accomplished by focusing on the end result. Behavior controls specify how something is done through policies, rules, standard operating procedures and orders from supervisors. Input controls emphasize resources. Copyright © 2015 Pearson Education, Inc.

Activity-Based Costing allocates indirect and direct costs to individual product lines based on value-added activities going into that product Allows accountants to charge costs more accurately because it allocates overhead more precisely Activity-based costing (ABC) is a recently developed accounting method for allocating indirect and fixed costs to individual products or product lines based on the value-added activities going into that product. ABC accounting allows accountants to charge costs more accurately than the traditional method because it allocates overhead far more precisely Copyright © 2015 Pearson Education, Inc.

Enterprise Risk Management corporate-wide, integrated process for managing uncertainties that could negatively or positively influence the achievement of objectives Enterprise Risk Management is the corporate-wide, integrated process for managing uncertainties that could negatively or positively influence the achievement of objectives. Copyright © 2015 Pearson Education, Inc.

Enterprise Risk Management The process of rating risks involves three steps: Identify the risks using scenario analysis, brainstorming or performing risk assessments Rank the risks, using some scale of impact and likelihood Measure the risks using some agreed-upon standard The process of rating risks involves three steps: 1. Identify the risks using scenario analysis or brainstorming or by performing risk self-assessments 2. Rank the risks, using some scale of impact and likelihood 3. Measure the risks, using some agreed-upon standard Copyright © 2015 Pearson Education, Inc.

Traditional Financial Measures Return on investment (ROI) result of dividing net income before taxes by the total amount invested in the company (typically measured by total assets) Earnings per share (EPS) dividing net earnings by the amount of common stock The most commonly used measure of corporate performance (in terms of profits) is return on investment (ROI). It is simply the result of dividing net income before taxes by the total amount invested in the company (typically measured by total assets). Earnings per share (EPS), which involves dividing net earnings by the amount of common stock. Copyright © 2015 Pearson Education, Inc.

Traditional Financial Measures Return on equity (ROE) involves dividing net income by total equity Operating cash flow the amount of money generated by a company before the cost of financing and taxes, is a broad measure of a company’s funds Free cash flow the amount of money a new owner can take out of the firm without harming the business. Return on equity (ROE) involves dividing net income by total equity. Operating cash flow, the amount of money generated by a company before the cost of financing and taxes, is a broad measure of a company’s funds. Some takeover specialists look at a much narrower free cash flow: the amount of money a new owner can take out of the firm without harming the business. Copyright © 2015 Pearson Education, Inc.

Nonfinancial Performance Measures Used by Internet Business Ventures Stickiness length of Web site visit Eyeballs number of people who visit a Web site Mindshare brand awareness For example, some nonfinancial performance measures used by Internet business ventures are stickiness (length of Web site visit), eyeballs (number of people who visit a Web site), and mindshare (brand awareness). Copyright © 2015 Pearson Education, Inc.

Copyright © 2015 Pearson Education, Inc. Shareholder Value Shareholder value the present value of the anticipated future streams of cash flows from the business plus the value of the company if liquidated Economic value added (EVA) measures the difference between the pre- strategy and post-strategy values for the business after-tax operating income minus the total annual cost of capital Shareholder value can be defined as the present value of the anticipated future stream of cash flows from the business plus the value of the company if liquidated. EVA measures the difference between the pre-strategy and post-strategy values for the business. Simply put, EVA is after-tax operating income minus the total annual cost of capital. Copyright © 2015 Pearson Education, Inc.

Copyright © 2015 Pearson Education, Inc. Shareholder Value Market value added (MVA) measures the difference between the market value of a corporation and the capital contributed by shareholders and lenders Measures the stock market’s estimate of the net present value of a firm’s past and expected capital investment projects Market value added (MVA) is the difference between the market value of a corporation and the capital contributed by shareholders and lenders. Like net present value, it measures the stock market’s estimate of the net present value of a firm’s past and expected capital investment projects. Copyright © 2015 Pearson Education, Inc.

Copyright © 2015 Pearson Education, Inc. Balanced Score Card Balanced scorecard combines financial measures that tell the results of actions already taken with operational measures on customer satisfaction, internal processes and the corporation’s innovation and improvement activities—the drivers of future financial performance The balanced scorecard combines financial measures that tell the results of actions already taken with operational measures on customer satisfaction, internal processes and the corporation’s innovation and improvement activities—the drivers of future financial performance. Copyright © 2015 Pearson Education, Inc.

Copyright © 2015 Pearson Education, Inc. Balanced Score Card In the balanced scorecard, management develops goals or objectives in each of four areas: Financial: How do we appear to shareholders? Customer: How do customers view us? Internal business perspective: What must we excel at? Innovation and learning: Can we continue to improve and create value? In the balanced scorecard, management develops goals or objectives in each of four areas: Financial: How do we appear to shareholders? Customer: How do customers view us? Internal business perspective: What must we excel at? Innovation and learning: Can we continue to improve and create value? Copyright © 2015 Pearson Education, Inc.

Copyright © 2015 Pearson Education, Inc. Balanced Score Card Key performance measures measures that are essential for achieving a desired strategic option Each goal in each area (for example, avoiding bankruptcy in the financial area) is then assigned one or more measures, as well as a target and an initiative. These measures can be thought of as key performance measures—measures that are essential for achieving a desired strategic option. Copyright © 2015 Pearson Education, Inc.

Chairman-CEO Feedback Instrument Questionnaire focuses on four key areas: Company performance, Leadership of the organization Team-building and management succession Leadership of external constituencies The questionnaire focuses on four key areas: (1) company performance, (2) leadership of the organization, (3) team-building and management succession and (4) leadership of external constituencies. Copyright © 2015 Pearson Education, Inc.

Copyright © 2015 Pearson Education, Inc. Management Audit Management audits developed to evaluate activities such as corporate social responsibility, functional areas such as the marketing department, and divisions such as the international division useful to boards of directors in evaluating management’s handling of various corporate activities Management audits are very useful to boards of directors in evaluating management’s handling of various corporate activities. Management audits have been developed to evaluate activities such as corporate social responsibility, functional areas such as the marketing department, and divisions such as the international division. Copyright © 2015 Pearson Education, Inc.

Copyright © 2015 Pearson Education, Inc. Strategic Audit Strategic audit provides a checklist of questions, by area or issue, that enables a systematic analysis of various corporate functions and activities to be made useful as a diagnostic tool to pinpoint corporate-wide problem areas and to highlight organizational strengths and weaknesses The strategic audit provides a checklist of questions, by area or issue, that enables a systematic analysis of various corporate functions and activities to be made. It is a type of management audit and is extremely useful as a diagnostic tool to pinpoint corporate-wide problem areas and to highlight organizational strengths and weaknesses. Copyright © 2015 Pearson Education, Inc.

Responsibility Centers used to isolate a unit so it can be evaluated separately from the rest of the corporation has its own budget and is evaluated on its use of budgeted resources headed by the manager responsible for the center’s performance Responsibility centers are used to isolate a unit so it can be evaluated separately from the rest of the corporation. Each responsibility center, therefore, has its own budget and is evaluated on its use of budgeted resources. It is headed by the manager responsible for the center’s performance. Copyright © 2015 Pearson Education, Inc.

Responsibility Centers Standard cost centers Revenue centers Expense centers Profit centers Investment centers Standard cost centers are primarily used in manufacturing facilities. With revenue centers, production, usually in terms of unit or dollar sales, is measured without consideration of resource costs (for example, salaries). Typical expense centers are administrative, service and research departments. A profit center is typically established whenever an organizational unit has control over both its resources and its products or services. An investment center’s performance is measured in terms of the difference between its resources and its services or products. Copyright © 2015 Pearson Education, Inc.

Copyright © 2015 Pearson Education, Inc. Benchmarking Benchmarking the continual process of measuring products, services and practices against the toughest competitors or those companies recognized as industry leaders Benchmarking is “the continual process of measuring products, services, and practices against the toughest competitors or those companies recognized as industry leaders.” Copyright © 2015 Pearson Education, Inc.

Copyright © 2015 Pearson Education, Inc. Benchmarking Identify the area or process to be examined Find behavioral and output measures Select an accessible set of competitors of best practices Calculate the differences among the company’s performance measurements and those of the competitors and determine why the differences exist Develop tactical programs for closing performance gaps Implement the programs and compare the results The benchmarking process usually involves the following steps: Identify the area or process to be examined Find behavioral and output measures Select an accessible set of competitors of best practices Calculate the differences among the company’s performance measurements and those of the competitors and determine why the differences exist Develop tactical programs for closing performance gaps Implement the programs and compare the results Copyright © 2015 Pearson Education, Inc.

Strategic Information Systems Enterprise Resource Planning (ERP) unites all of a company’s major business activities within a single family of software modules providing instant access throughout the organization Many corporations around the world have adopted enterprise resource planning (ERP) software. ERP unites all of a company’s major business activities, from order processing to production, within a single family of software modules. The system provides instant access to critical information to everyone in the organization, from the CEO to the factory floor worker. Copyright © 2015 Pearson Education, Inc.

Strategic Information Systems Radio frequency identification (RFID) an electronic tagging technology used to improve supply-chain efficiency Divisional and functional IS support used to support, reinforce or enlarge business-level strategy throughout the decision support system Radio frequency identification (RFID) is an electronic tagging technology used in a number of companies to improve supply-chain efficiency. By tagging containers and items with tiny chips, companies use the tags as wireless barcodes to track inventory more efficiently. At the divisional or SBU level of a corporation, the information system should be used to support, reinforce or enlarge its business-level strategy through its decision support system. Copyright © 2015 Pearson Education, Inc.

Problems in Measuring Performance Lack of quantifiable objectives or performance standards Inability to use information systems to provide timely and valid information The lack of quantifiable objectives or performance standards and the inability of the information system to provide timely and valid information are two obvious control problems. Copyright © 2015 Pearson Education, Inc.

Short-Term Orientation Long-term evaluations may not be conducted because executives: Don’t realize their importance Believe that short-term considerations are more important than long-term considerations Aren’t personally evaluated on a long-term basis Don’t have the time to make a long-term analysis Long-term evaluations may not be conducted because executives (1) don’t realize their importance, (2) believe that short-term considerations are more important than long-term considerations, (3) aren’t personally evaluated on a long-term basis or (4) don’t have the time to make a long-term analysis. Copyright © 2015 Pearson Education, Inc.

Copyright © 2015 Pearson Education, Inc. Goal Displacement Goal displacement confusion of means with ends and occurs when activities originally intended to help managers attain corporate objectives become ends in themselves—or are adapted to meet ends other than those for which they were intended behavior substitution and suboptimization Goal displacement is the confusion of means with ends and occurs when activities originally intended to help managers attain corporate objectives become ends in themselves—or are adapted to meet ends other than those for which they were intended. Types of goal displacement are behavior substitution and suboptimization. Copyright © 2015 Pearson Education, Inc.

Copyright © 2015 Pearson Education, Inc. Goal Displacement Behavior substitution refers to the phenomenon of when people substitute activities that do not lead to goal accomplishment for activities that do lead to goal accomplishment because the wrong activities are being rewarded Behavior substitution refers to the phenomenon of when people substitute activities that do not lead to goal accomplishment for activities that do lead to goal accomplishment because the wrong activities are being rewarded. Copyright © 2015 Pearson Education, Inc.

Copyright © 2015 Pearson Education, Inc. Goal Displacement Suboptimization refers to the phenomenon of a unit optimizing its goal accomplishment to the detriment of the organization as a whole Suboptimization refers to the phenomenon of a unit optimizing its goal accomplishment to the detriment of the organization as a whole. Copyright © 2015 Pearson Education, Inc.

Guidelines for Proper Control Controls should involve only the minimum amount of information needed to give a reliable picture of events. Controls should monitor only meaningful activities and results, regardless of measurement difficulty. Controls should be timely so that corrective action can be taken before it is too late. Long-term and short-term goals should be used. Controls should aim at pinpointing exceptions. Emphasize the reward of meeting or exceeding standards rather than punishment for failing to meet standards. The following guidelines are recommended: Controls should involve only the minimum amount of information needed to give a reliable picture of events. Controls should monitor only meaningful activities and results, regardless of measurement difficulty. Controls should be timely so that corrective action can be taken before it is too late. Long-term and short-term goals should be used. Controls should aim at pinpointing exceptions. Emphasize the reward of meeting or exceeding standards rather than punishment for failing to meet standards. Copyright © 2015 Pearson Education, Inc.

Approaches to Strategic Incentive Management Weighted-factor method Long-term evaluation method Strategic funds method The following three approaches are tailored to help match measurements and rewards with explicit strategic objectives and time frames: Weighted-factor method Long-term evaluation method Strategic funds method Copyright © 2015 Pearson Education, Inc.

Business Strength/ Competitive Position Figure 11-2 Using portfolio analysis, one corporation’s measurements might contain the following variations: the performance of high-performing (star) SBUs is measured equally in terms of ROI, cash flow, market share and progress on several future-oriented strategic projects; the performance of low-growth, but strong (cash cow) SBUs, in contrast, is measured in terms of ROI, market share and cash generation; and the performance of developing question mark SBUs is measured in terms of development and market share growth with no weight on ROI or cash flow. (Refer to Figure 11–2.) Copyright © 2015 Pearson Education, Inc.

Approaches to Strategic Incentive Management An effective way to achieve the desired strategic results through a reward system is to combine the three approaches: Segregate strategic funds from short-term funds Develop a weighted-factor chart for each SBU Measure performance based on pre-tax profit, weighted factors and long-term evaluation of the SBU’s performance An effective way to achieve the desired strategic results through a reward system is to combine the three approaches: Segregate strategic funds from short-term funds Develop a weighted-factor chart for each SBU Measure performance based on pre-tax profit, weighted factors and long-term evaluation of the SBU’s performance Copyright © 2015 Pearson Education, Inc.

Copyright © 2015 Pearson Education, Inc.